The Bank of England has made a U-turn in its treatment of banks struggling to deal with the credit crunch.

It has announced that it will inject £10bn into the money markets in an attempt to bring three-month inter-bank interest rates down.

Crucially, the assets that banks are allowed to use as collateral will be wider than usual and will include their mortgage debt.

The Bank had previously said it was not its job to lower three-month rates.

BBC Business Editor Robert Peston says that under the Bank of England injection, individual banks can only apply for £1.5bn each under the £10bn facility.

The Bank also says that Northern Rock would have needed far greater funds - and that if this facility had been provided three weeks ago or so, the liquidity would not have eliminated the Rock's funding difficulties.

U-turn?

"This is exactly what it said it would rather not do in the letter to the Treasury Select Committee last week," said Alan Clarke at BNP Paribas.

"Clearly the financial market situation has deteriorated to the point that the slowdown implied for the economy is more severe than the Bank had seen as desirable," he added.

The British Bankers' Association welcomed the announcement saying it would ease the very tight conditions that have been seen in money markets in recent weeks.

"This response will contribute towards increased confidence after the extreme events of the past few days," said its chief executive Angela Knight.

Punitive rate

As part of their normal functioning, banks usually borrow money from each other on a regular basis.

The rate at which they borrow this money is known as the London Interbank Offered Rate, or Libor.

In recent weeks, the three-month Libor has risen not only above the Bank of England's base rate of 5.75%, but also above its punitive emergency lending rate of 6.75%.

This suggested that banks were reluctant to lend each other money because of the uncertainty in the market.

The uncertainty related to the value of various bundles of debt that had been bought from banks in the US and were based on sub-prime mortgages, which are those offered to people on low incomes or with inferior credit histories.

Debt exposure

As a result of the uncertainty, banks did not want to lend their spare cash to other banks because they thought they might need it themselves.

Also, nobody was sure whether the other banks were creditworthy, because they might be heavily exposed to sub-prime mortgage debt.

The US Federal Reserve and European Central Bank have been making funds available to US and European banks since the credit crunch began, but the Bank of England has resisted doing so until now.

There is concern about a potential "moral hazard", which is that if banks that have decided to buy risky debt do not lose out, there will be no incentive for them not to take risky decisions in the future.

The Bank of England's governor, Mervyn King, will appear before parliament's Treasury Select Committee on Thursday to answer questions about the current market problems and the credit crunch.